The first step is to ask yourself a set of questions that will guide you towards finding a truly magnificent business to own.
Do you understand the business?
This is crucial because if you don’t understand what you are buying you won’t know what value to put on it and how it will perform in the future. Knowing what a company does and how it does it is an important starting place in deciding what to put your money into. You should think like an owner of the company and be proud of being part of it.
Does the business posses a lasting competitive edge?
We want a business that looks as though it might be really tough to get into to be successful. A good example of this is Wal-Mart. If you want to buy motor oil, you won’t find a cheaper price anywhere else. In fact their prices are so low they cause other smaller businesses around them to close shop. If you want to compete with them you have to find a way to keep your prices low, something that is very difficult to accomplish for a new business which lacks capital.
A company has a competitive edge if it has developed a solid brand name such as McDonald’s where customers are willing to pay more for its products because they trust it. A company that has a trade secret or a patent that makes direct competition very difficult or illegal. A good example of that is Coca Cola and its secrete syrup recipe that prevents you and me from duplicating the product. Another type of competitive advantage is when a business has exclusive control over a market such as Time Warner Cable. Lastly, a business that’s so much part of your life that switching is not worth the trouble. Even though Linux offers its platform for free it still hasn’t managed to gain customers to switch. That is because switching from one operating system to another can be so difficult as to be prohibitive.
Does the business have great management?
The CEO of you company should have his personal interest directly aligned with the shareholders of the business. Is he/she telling us (the owners) what we need to know to be properly informed about the business? There are CEOs out there that will avoid mentioning any problems that we should know of because they are afraid of looking bad or creating a bigger problem. To find out more about a CEO, you can go online to sites such as The Wall Street Journal, Business Week, Forbes, The Economist and run a search by entering the CEOs name. You can get a lot of clues from well researched articles on whether or not he or she is the kind of person you want to invest with.
Another way to evaluate management is to view the compensation paid to the CEO. You should be aware of CEOs who get up to go to work in the morning not because they are commitment to the business, but are strictly motivated by the outrageous perks and salaries. Their loyalty to the cause goes about as deep as the depth of their paychecks. Stay away from companies where management gets overpaid.
Picking a Winner!
Hopefully you were able to come up with many different companies you wish to invest in after carefully going through each of the above three questions. Businesses that lack the history to make a prediction of the future possible are inherently risky. We will be relying on past data to predict the future success of that company so we will want to choose a company that is well established and has been in business for at least 5 years. You will want to screen each company for the following criteria:
Book Value per share growth rate
Earnings per share growth rate
Free Cash Flow growth rate
Return on Investment Capital
Each of these number should preferably equal to or greater than 10% for the last 5 years. The first thing you want to do is check for consistency in the numbers just by looking at them. You want to see a steady, upward-trending line. One should note that even though the numbers for a company may be good in the past, it doesn’t mean they’ll be good in the future. A good business can run out of people to sell goods and services to or its profits may be negatively impacted by a successful new competitor in the market. But at least with a good historical consistency we can hope for a steady future based on expectations that the business will continue to do what it’s been doing. You now know how to invest, check out our Buy Recommendations and let us know what you think.